Is Keynes Finally Dead?

In the immediate aftermath of the debt ceiling deal in August, liberal Democrats on Capitol Hill felt as though they had been flattened by the Tea Party express. The plan promised $2.1 trillion in budget cuts over the next decade. For conservatives, that was not a huge amount of savings out of $44 trillion in anticipated federal spending. But the left was apoplectic about even a haircut for government programs. Senator Richard Durbin, the Illinois Democrat, fumed that the agreement and its $21 billion of savings in 2011 might as well be "the final interment of John Maynard Keynes." He continued glumly: "Keynes died in 1946 but it appears we are [now] going to put him to his final rest."

Now that's a pleasant thought. Keynes was, of course, the influential Depression-era British economist who advised politicians to ramp up government spending, borrowing, and printing of money during an economic downturn in order to prop up demand for goods and services and thus return to prosperous times. Borrow now, from future generations, and let the kids worry about it, because, as he famously said, "in the long run, we are all dead." That philosophy has been the guiding doctrine of liberalism for at least 75 years. So triumphantly has this doctrine penetrated academia and politics that President Richard Nixon famously declared, "We are all Keynesians now."

The leader of this new branch of economics was, for a long time, the late and highly influential Keynesian disciple Paul Samuelson. He was to Keynesianism what Paul was to the spreading of Christianity. Mr. Samuelson's tour de force was his best-selling textbook, Economics: An Introductory Analysis. Written in the late 1940s, and with more than 4 million in sales, the book has indoctrinated three generations of students with its illogic.

Samuelson was enamored with the power and wisdom of the political class to tinker with the economy to make it function like a well-oiled machine. He was godfather of the idea of pumppriming an underperforming economy with more federal spending and more money. He believed so powerfully in the efficacy of government tinkering that, in the Cold War years, he routinely warned that the Soviet economy would catch up to the U.S. In the 1989 edition of his textbook, he wrote: "The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive." A year later the Soviet economy imploded and the Berlin Wall came down. One would think that would have been pretty much the end of the line for America's first Nobel-prize winning economist. Since then at least a dozen of Samuelson's disciples have won the prize.

Keynesianism is based on the flawed idea that the economic problem underlying recessions is insufficient consumer demand for goods and services, and that by goosing demand with free money the government can increase output and employment. As Doug Holtz-Eakin, former director of the Congressional Budget Office, explains, "The idea behind Obamanomics and Keynesianism is that the government can trick people into spending more money than they would otherwise." It turns out people aren't that gullible.

Seldom has an economic theory been so thoroughly rebutted by real world events. After eight years of the first grand Keynesian experiment -- the New Deal during the Great Depression -- the unemployment rate in 1939 was 20.7 percent and output was still growing at a crawl, seven years after Franklin Delano Roosevelt took office. That's some victory. As Burton Fulsom, author of the Depression history New Deal or Raw Deal, has argued: "The greatest myth of the twentieth century is that Franklin Roosevelt's New Deal ended the Great Depression."

Japan has employed textbook Keynesianism for 20 years and nearly the whole island has been paved over by public works projects, yet the economy continues to flounder and asset values are still only half what they were in 1990.

BUT THE MOST EMBARRASSING repudiation of Keynes has been the Great Recession of 2008– 2011. Never in modern times has the premise that open-checkbook government spending and pedal- to-the-metal money creation lead to economic growth been put to such a large-scale trial. The results have been completely the opposite of what was predicted.

The key to the magic of Keynesianism is to boost growth in demand by running economically expansionary deficits. In 2008 President George W. Bush doubled the deficit by enacting a $100 billion Keynesian tax rebate. Then, in 2009 we ran a $1.4 trillion deficit, thanks in large part to President Obama's $830 billion stimulus plan. This was double any other deficit, in real dollars, in peacetime history and by far the largest as a share of GDP (at 10 percent) in peacetime history.

In 2010 we ran another $1.3 trillion deficit, followed by $1.3 trillion more this year. So that's $4.0 trillion of debt, which has produced -- drum roll, please -- 9.1 percent unemployment and GDP growth of less than 1.0 percent -- barely an economic pulse. Every major economic forecaster has downgraded their predicted growth rate for 2012, and there's now more panicked talk of a double-dip recession.

The Keynesians' retort is what it always is when their ideas are shown to fail: we haven't had enough stimulus for long enough. The White House is now arguing that Neanderthal Republican tea partiers turned off the spending and borrowing spigot way too soon. Christina Romer, the first chief economic adviser to Mr. Obama, regrets that "we only got one shot" at stimulus and her prescription is "more."

This was the excuse for why Keynesianism failed to reverse the Great Depression. Those short-sighted Republicans in 1937 allegedly turned off the debt machine, insisted on balancing the budget, and once the medicine was shut off, the economy tanked again. But there was no prosperity in the 1930s at any time after FDR doubled federal spending and government debt as a share of GDP. Unemployment never fell below 10 percent until millions of young people donned uniforms and the nation mobilized for World War II.

In any case, where is the evidence that Keynesian fiscal stimulus has been put on hold this year? There is none. The 2012 deficit is going to be roughly 10 percent of GDP, which, five years ago, would have been considered an unthinkable level of pump-priming. Federal spending is up $140 billion this year, and that is layered on top of the massive stimulus of 2009 and 2010. The latest GDP numbers show that federal government spending was one of the few areas where the economy expanded in the first half of this year-- even as much of the private economy flat-lined. And many have forgotten that we got a further dose of stimulus that was guaranteed to produce jobs back in December when Mr. Obama won a one-year payroll tax cut with a price tag of $112 billion. That has corresponded with a rise, not a fall, in the unemployment rate, yet the White House wants to extend it for another year.

In other words, the current Keynesian argument is that $100 billion of stimulus a month isn't enough. That we need, what? Another $150 or $200 billion a month in deficits to make the economy grow? And if that $2 trillion isn't enough, then what?

Maybe QE3 from Ben Bernanke and the Fed. Those who say "more stimulus, please" forget that the Federal Reserve has run the most expansionary money creation strategy in history, first through near-zero interest rates, and next through asset purchases, known as QE1 ($1.2 trillion in mostly mortgage-backed securities purchased by the Fed in 2009), followed by QE2. QE2 started late last year and pumped $600 billion into the economy through the purchase of U.S. Treasury securities. But that latest debt and money pump-priming has corresponded with this year's economic slowdown. And the resulting higher prices in gasoline and food have made Americans feel poorer not richer, thus dampening consumer demand. Oops.

Time out for a historical digression. One can't listen to the left these days order up more and more deficit spending without harkening back to the early 1980s, when Ronald Reagan rescued the U.S. from the greatest financial collapse since the Depression. In the 1970 and early 1980s, the stock market in real terms lost almost 70 percent of its value. Reagan slammed the brakes on money and cut tax rates. The deficits of that era averaged about 5 percent of GDP. Back then many leading Keynesians, including Samuelson, first swore this would never tame inflation and restore growth, then by 1984, when the economy grew at 7 and even 8 percent, they shrugged and posited: this was simply a classic Keynesian recovery. The deficits caused the growth. Never mind that other nations that ran even bigger deficits didn't grow. And back then, hypocritical liberals trashed Reagan for running deficits they now trumpet as virtuous. One of the few exceptions was Robert Eisner of Northwestern, who applauded Reagan's deficits. He was one of the few honest Keynesians of his day.

BUT HERE'S THE POINT: if Reagan's deficits caused a 7 percent growth rebound with deficits of 5 percent of GDP, why have Obama's deficits, which are twice as large, generated only 1 to 2 percent growth?

The answer is that Reagan's supply-side, tax rate-cut policies, not the deficits, stimulated production and investment, not demand. In nominal terms, demand grew very little in the mid-1980s. You can't have a demand-side Keynesian expansion with falling prices; it's impossible within that model.

The fundamental flaw in the theory of government as pump primer is that the public sector can only get a dollar to spend in the first place by parasitically taking it from the more productive private sector, which is why the mythical "multiplier effect" of government spending -- the increase in total GDP for each dollar spent by the government -- is less than one. Robert Barro of Harvard has found exactly that in his empirical studies on stimulus spending. He found that government spending often crowds out private spending, rather than stimulating it.

But now, in the 21st century, Keynesianism has run into a new and formidable impediment to its deficit theories: global bond vigilantes. They are telling nations that debt-financed stimulus spending has run its course. Interest rates have soared in many eurozone nations like Greece and Ireland. Yet the U.S. is attracting so many bond buyers that interest rates are at 30-year lows. How long can this bubble inflate? Meanwhile, Fed Chairman Bernanke's zero interest rate and asset purchasing schemes have driven gold to $1,800 plus an ounce, as investors lose trust in paper currencies. Will it take a 2008 style financial panic to get Washington to understand that the free-lunch era is over?

Perhaps the biggest lie from the Keynesians is the premise that -- with so many Americans unemployed -- we should delay cuts in spending during this soft patch in the economy and lock in long-term cuts in entitlements in future years, when the economy is growing. This is the Obama pitch. But when have Democrats (or even Republicans for that matter) ever in any of our lifetimes said, "Now is the time to cut spending"? Nancy Pelosi has sprinted to the microphone after every negotiation with Republicans pledging that there would be no cuts in Social Security, Medicare, and Medicaid—not now, not next year, not ever. These are the programs that nearly everyone acknowledges are driving the red ink tsunami, with budgets that are expected to climb to $2.4 trillion from $1.6 trillion this year, and yet they are labeled untouchable by the fiscal doves.

Republicans would be fools to fall for the "spend now, save later" gambit. This is the attitude of a teenage girl roaming the mall with daddy's credit card. It is a promise never to cut spending. That's because Keynesianism isn't a real scientific economic theory. As economist Don Boudreaux of George Mason University puts it: "When you get right down to it, Keynesianism is just a convenient excuse for what the left wants to do anyway: spend more government money." It has left us with a $14.5 trillion national debt and an economy flat on its back.

Now Obama and the rest of Keynesian cult say that if we can just spend and borrow more, the economy will get better and the jobs will come back. If there's any good news from the events of the last three years it's that Dick Durbin may be right: almost no sane person really believes that anymore.

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